UNIT IV

Marginal Costing
1. Introduction:
Two general approaches are used for costing products for the purpose of valuing inventories and
cost of goods sold. One approach is called absorption costing. Absorption costing is generally
used for external financial reports. The other approach called variable costing, is preferred by
some companies for internal decision making and must be used when an income statement is
prepared in the contribution format. Ordinarily, absorption costing and variable costing produce
different figures for net income and the difference can be quite large. Under variable costing,
only those cost of production that vary with output and treated as product cost. This would
generally include direct material, direct labour and the variable portion of manufacturing
overhead. Fixed manufacturing overhead is treated as cost of the period and charged to the
period. Variable costing is sometimes referred to as direct costing, marginal costing, differential
costing, incremental costing and comparative costing. The break even profit analysis examines
the behaviour of total revenues, total costs and operating income as changes occur in the output
level, the selling price, the variable cost per unit and/or the fixed costs of a product. Mangers use
cost volume analysis to help answer questions such as. How will total revenues and total costs
be affected if the output level changes. In this way marginal costing and break even analysis
guides manager’s planning.
2 Marginal Cost and Marginal Costing
The Institute of Cost and Management Accountants, London, has defined ‘marginal cost’ as “the
amount at any given volume of output by which aggregate costs are changed as if the volume of
output is increased or decreased by one unit”. In this context, a unit may be a single unit, a batch
of articles, an order, a stage of production capacity, a process or a department. Suppose the cost
of production of 1,000 units is Rs. 6,000 and that of 1,001 units is Rs. 6,004, the marginal cost
is Rs. 4. Marginal cost is the variable cost comprising the cost of direct materials consumed,
direct wages paid and the variable overhead incurred for producing the additional unit.

The ICMA, England has defined marginal cost as “the cost for producing one additional unit of
product”. It has also been defined as, “the amount charges in the aggregate cost due to changes
in the existing level production by one unit”. An analysis of these definitions reveals that the
marginal cost is the cost producing an additional unit. That means, marginal cost refers to the
extra costs for the production of an additional unit.
Marginal Costing:
The institute of Cost and Works Accountants of India (ICWAI) defines marginal costing as, “A
method considers only the variable cost as cost of production, leaving out period costs to be
absorbed from the marginal contribution.” Batty defines marginal costing as, “a technique of
cost accounting which pays special attention to the behaviour of costs with charges in the volume
of output”. When compared to the definition by the ICWAI, the definition by the Chartered
institute of Management Accountants (CIMA), England appears to be more comprehensive.
Because, the ICWA, England defines marginal cost and effect of changes in volume or type of
output on the company’s profit, by segregating total costs into variable and fixed costs.
4. Characteristics of Marginal Costing:
1. Marginal costing is a technique or working of costing, which is used in conjunction with
other methods of costing (process or job).
2. Fixed and variable costs are kept separate at every stage. Semi variable costs are also
separated into fixed and variable.
3. As fixed costs are period costs; they are excluded from product cost or cost of production or
cost of sales. Only variable costs are considered as the cost of the product.
4. When evaluation of finished goods and work-in-progress are taken into account, they will
be only variable costs.
5. As fixed costs are period costs, they recharged to profit and loss account during the period
in which they are incurred. They are not carried forward to the next year’s income.
6. Marginal income or marginal contribution is known as the income or the profit.
7. The difference between the contributions is known as the income or the profit.
8. Fixed costs remain constant irrespective of level of activity.
9. Sales price and variable cost per unit remain the same.
10. Cost-volume-profit relationship is fully employed to reveal the state of profitability at
various levels of activity.
5. Advantages of Marginal costing
1. Constant in nature: Variable costs fluctuate from time to time, but in the long run, marginal
costs are stable. Marginal costs remain the same, irrespective of the volume of production.
2. Effective cost control: It divides cost into fixed and variable. Fixed cost is excluded from
product. As such, management can control marginal cost effectively.
3. Treatment of overheads simplified: It reduces the degree of over or underrecovery of
overheads due to the separation of fixed overheads from production cost.
4. Uniform and realistic valuation: As the fixed overhead costs are excluded from product
cost, the valuation of work-in-progress and finished goods becomes more realistic.
5. Helpful to management: It enables the management to start a new line of production which
is advantageous. It is helpful in determining which is profitable – whether to buy or
manufacture a product. The management can take decision regarding pricing and tendering.
6. Helps in production planning: It shows the amount of profit at every level of output with
the help of cost volume profit relationship. Here the break-even chart is made use of.
7. Better result: When used with standard costing, it gives better results.
8. Fixation of selling price: The differentiation between fixed costs and variable costs is very
helpful in determining the selling price of the products or services. Sometimes, different prices
are charged for the same article in different markets to meet varying degrees of competition.
9. Helpful in budgetary control: The classification of expenses is very helpful in budgeting
and flexible budget for various levels of activities.
10. Preparing tenders: Many business enterprises have to compete in the market in quoting
the lowest price. Total variable cost, when separately calculated, becomes the ‘floor price’.
Any price above this floor price may be quoted to increase the total contribution.
11. “Make or Buy” decision: Sometimes a decision has to made whether to manufacture a
component or a product or to buy it readymade from the market. The decision to purchase it
would be have taken if the price paid recovers some of the fixed expenses.
12. Better presentation: The statements and graphs prepared under marginal costing are better
understood by management executives. The break-even analysis presents the behaviour of cost,
sales, contribution etc. in terms of charts and graphs. And, thus the results can easily be grasped.

6. Limitations of Marginal Costing:

1. Difficulty to analyse overhead: Separation of costs into fixed and variable is a difficult
problem. In marginal costing, semi-variable or semi-fixed costs are not considered.
2. Time element ignored: Fixed costs and variable costs are different in the short run; but in
the long run, all costs are variable. In the long run all costs change at varying levels of
operation. When new plants and equipment’s are introduced, fixed costs and variable costs will
vary.
3. Unrealistic assumption: Assumption of sale price will remain the same at different levels
of operation. In real life, they may change and give unrealistic results.
4. Difficulty in the fixation of price: Under marginal costing, selling price is fixed on the basis
of contribution. In case of cost plus contract, it in very difficult to fix price.
5. Complete information not given: It does not explain the reason for increase in production
or sales.
6. Significance lost: In capital – intensive industries, fixed cost occupies major portions in the
total cost. But marginal costs cover only variable costs. As such, it loses its significance in
capital industries.
7. Problem of variable overheads: Marginal costing overcomes the problem of over and
under-absorption of fixed overheads. Yet there is the problem in the case of variable overheads.
8. Sales-oriented: Successful business has to go in a balanced way in respect of selling
production functions. But marginal costing is criticized on account of its attaching over
importance to selling function. Thus, it is said to be sales-oriented. Production function is given
less importance.
9. Unreliable stock valuation: Under marginal costing stock of work-in-progress and finished
stock is valued at variable cost only. No portion of fixed cost is added to the value of stocks.
Profit determined, under this method, is depressed.
10. Claim for loss of stock: Insurance claim for loss or damage of stock on the basis of such
a valuation will be unfavourable to business.
11. Automation: Now-a-days increasing automation is leading to increase in fixed costs. If
such increasing fixed costs are ignored, the costing system cannot be effective and dependable.
Marginal costing, if applied alone, will not be much in use, unless it is combined with other
techniques like standard costing and budgetary control.
7. Absorption costing and marginal costing:
Absorption costing is the practice of charging all costs, both fixed and variable to operations,
process or products. In marginal costing, only variable costs are charged to production.
The Institute of Cost and Management Accountants (U.K.) defines it as, “the practice of
charging all costs, both variable and fixed to operations, processes or products”. This explains
why this technique is also called full costing. Administrative, selling and distribution overheads
as much form part of total cost as prime cost and factory burden.
Distinction between absorption costing and marginal costing
Points of Distinction Absorption Costing Marginal Costing
Charging of costs Fixed costs form part of total Variable costs alone form
costs of production and part of cost of production,
distribution. and sales whereas fixed costs
are charged against
contribution for
determination of profit.
Valuation of stocks Stocks and work-in-progress Stocks are valued at variable
are valued at both fixed and cost only.
variable costs i.e., total cost.
Variation in profits When there is no sales, the If there are no sales, the fixed
entire stock is carried overhead will be treated as
forward and there is no loss in the absence of
trading profit or loss. contribution. It is not carried
forward as part of stock
value.
Purpose Absorption costing is more Marginal costing is more
suitable for longterm useful for short-term
decision making and for managerial decision making.
pricing policy over long-
term.
Emphasis Absorption costing lays Absorption costing lays
emphasis on production. emphasis on production.

8. Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit analysis is the analysis of three variables viz., cost, volume and profit. This
analysis measures variations of costs and volumes and their impact on profit. Profit is affected
by several internal and external factors which influence sales revenue and costs.
Cost-volume-profit analysis helps the management in profit planning. Profit of a concern can
be increased by increasing the output and sales or reducing cost. If a concern produces to the
maximum capacity and sell, contribution is also increased to the maximum level.
Heiser puts it is the following words: “The most significant single factor in planning of the
average business is the relationship between the volume of business, its costs and profit”.
Thus, cost volume and profit analysis is an attempt to measure the effect of changes in volume,
cost, price and product mix on profits. With the increase in volume unit cost of production
decreases and vice versa, because the fixed costs are constant. With the decrease in fixed cost
per unit profit will be more. Cost-volume-profit analysis is made with the objective of
ascertaining the following:
(1) The cost for various levels of production.
(2) The desirable volume of production
(3) The profit at various levels of production.
(4) The difference between sales revenue and variable cost.
To know the cost volume profit relationship, a study of the following is essential.
1. Marginal cost statement,
2. Contribution,
3. Profit volume ratio,
4. Break-even analysis
5. Margin of safety
6. Angle of Incidence
1. Marginal cost statement
Particulars Rs. Rs.
Sales XXX
Less: Marginal/Variable Cost
Direct Materials XXX
Direct Labour/Wages XXX
Variable Cost/Overhead/Expenses XXX
Other Variable Costs XXX XXX
Contribution XXX
Less: Fixed Costs
Fixed Expenses/Overheads XXX
Profit XXX
Marginal Costing Equations

Sales = Variable Cost + Fixed Cost ± Profit or loss

Sales – Variable Cost = Fixed Cost ± Profit or loss
Sales – Variable Cost = Contribution
Contribution = Fixed Cost + Profit

From the above equation, we can understand that in order to earn profit, the contribution must
be more than the fixed cost. To avoid any loss, the contribution must be equal to fixed cost.
Contribution
Contribution is the difference between sales and marginal cost. It is the contribution towards
fixed cost and profit. In marginal costing technique contribution is a very important concept as
it is used to find the profitability of products, processes, departments and divisions. Practically
all decisions are based on and oriented towards contribution. Contribution is different from the
profit which is the net margin remaining after reducing fixed expenses from the total
contribution. Contribution can be ascertained as given below:

Contribution = Selling price – Marginal cost/Variable cost

Contribution = Fixed cost + Profit
Contribution – Fixed Cost = Profit.

Profit Volume Ratio (or) P/V Ratio (or) Contribution to Sales

This is the ratio of contribution to sales. It is an important ratio analysis the relationship
between sales and contribution. A high P/V ratio indicates high profitability and low P/V ratio
indicates low profitability. This ratio helps in comparison of profitability of various products.
Since high P/V ratio indicates high profits, the objective of every organization should be to
improve or increase the P/V ratio.
P/V Ratio can be improved by:
(1) Decreasing the variable cost by efficiently utilizing material, machines and men.
(2) Selecting most profitable product mix for production and sales.
(3) Increasing the selling price per unit.
Formula for P/V Ratio
Contribution
P/V Ratio = -------------------- X 100
Sales
(Or)
Sales-Variable Cost
P/V Ratio = -------------------- X 100
Sales
(Or)
Fixed Cost+ Profit
P/V Ratio = -------------------- X 100
Sales
When two periods’ profits and sales are given, the P/V ratio is calculated as given below:
Changes in Profit
P/V Ratio = -------------------- X 100
Changes in Sales

P/V Ratio is generally expressed as a percentage.

Break even Analysis (or) Break even Point (BEP)

Break even analysis is a method of studying relationship between revenue and costs in relation
to sales volume of a business enterprise and determination of volume of sales at which total
costs are equal to revenue. According to Matz Curry and Frank “a break-even analysis
determines at what level cost and revenue are in equilibrium”. Thus, break even analysis refers
to a system of determination of that level of activity where total sales are just equal to total
costs. This level of activity is generally termed as break-even point (BEP). At the break even
point a business man neither earns any profit nor incurs any loss. Break even point is also called
“No profit, no loss point” or “Zero profit & zero loss point”.
In the words. J. Wayne Keller “The Break-even point of a company or a unit of a company is
the level of sales income which will equal the sum of its direct costs (variable costs) and its
period expenses (fixed expenses)”.
Formula for calculating break even point
Fixed Expenses
Break Unit Points (in units) = --------------------
Contribution per unit
(or)
 Fixed cost
Break Unit Points (in units) = --------------------
Contribution per unit
(or)
Break even sales value
Break Unit Points (in units) = --------------------
Selling Price per unit

and
Fixed cost
Break Unit Points (in rupees) = --------------------
P/V Ratio
(or)
Break Unit Points (in rupees) = Actual sales/Present sales – BEP sales
Break Even Point (in rupees) = Break even point in units x Selling price per unit
Fixed Cost/Expenses
Break Unit Points (in rupees) = -------------------- X Selling Price per unit
Contribution per unit

Fixed Cost/Expenses
Break Unit Points (in rupees) = -------------------- X Sales
Contribution

Margin of Safety
Break even analysis includes the concept of margin of safety. Margin of safety is the difference
between actual sales and break even sales. Margin of safety is calculated in rupees, units or
even in percentage form. Margin of safety indicates the value/volume of sales which directly
contribute of profit, as fixed costs have already been recovered at break even point. Margin of
safety is calculated by the following formula:
Margin of Safety = Actual sales – Break even sales (or)
Profit
Margin of Safety = --------------------
P/V Ratio
Margin of safety ratio/ Percentage: Sometimes margin of safety is expressed as a ratio. It is the
ratio of margin of safety to actual sales.

Margin of Safety
Margin of Safety (in ratio/percentage) = -------------------- X 100
Actual / Present sales

Angle of Incidence
In graphic presentation of marginal cost data, i.e., a break-even chart, the total cost line and
sales line cross each other. The point of their crossing is termed ‘Break-even point’. The angle
at which the sales line crosses the total cost line is called the ‘Angle of incidence’.
The bigger is the angle, the more will be the contribution and profit with every additional sale.
Firms with higher P/V ratio and comparatively less variable costs have a higher angle of
incidence. Such firms can magnify their profits in high demand conditions.
The angle of incidence at a glance can signify or reveal the ability of a firm to earn higher
profits with every increase in sales.
Assumptions of Break-even analysis
1. Fixed costs remain the same and do not change with level of activity.
2. Costs are divided into fixed and variable costs. Variable costs change according to the
volume of production.
3. Variable cost vary with the volume of output but price of variable costs such as wage rate,
price of materials, supplies, will be unchanged.
4. Selling price remains the same at different levels of activity.
5. There is no change in the product mix.
6. There is no change in the level of efficiency.
7. Policies of management do not change.
8. No change in the manufacturing process is due to non-static operating efficiency.
9. As the number of units produced and sold are the same, there is no closing or opening stock.
Advantages of Break-Even Analysis
1. Total cost, variable cost and fixed cost can be determined.
2. B.E. output or sales value can be determined.
3. Cost, volume and profit relationship can be studied, and they are very useful to the
managerial decision – making.
4. Inter-firm comparison is possible.
5. It is useful for forecasting plans and profits.
6. The best products mix can be selected.
7. Total profits can be calculated.
8. Profitability of different levels of activity, various products or profit, i.e., plans can be
known.
9. It is helpful for cost control.
Application of Marginal Costing Techniques
Marginal costing is an extremely valuable technique with the management. The costvolume-
profit relationship has served as a key to locked storehouse of solutions to many situations. It
enables the management to tackle many problems which are faced in the practical business.
“All the introduction of marginal cost principles does is to give the management a fresh, and
perhaps a refreshing, insight into the progress of their business”. Now, we explain the
application of the techniques of marginal costing in certain important areas.
Marginal Costing helps the management in decision-making in respect of the following areas:
1. Cost control
2. Fixation of Selling Price
3. Closure of a Department or Discontinuing a Product
4. Selection of a Profitable Product Mix
5. Profit Planning
6. Decision to make or buy
7. Decision to accept a bulk order
8. Introduction of a new product
9. Choice of technique
10. Evaluation of performance
11. Maintaining a desired level of profit
12. Level of activity planning
13. Alternative methods of production
14. Introduction of product line